Friday, January 20, 2017

Since AA’s
province is finance and not theology, let’s look at collateral coverage.Maybe KHCB is so collateral “rich” that classifying
some loans past due 180 days as unimpaired makes perfect (credit) sense.

As outlined
above, KHCB’s collateral position is not sufficiently “robust” to compensate
for other weaknesses in its lending portfolio discussed in earlier posts.

Collateral
is concentrated in real estate. That poses at least two problems. Illiquid assets
like real estate are difficult to sell quickly and/or at full price, exposing
lenders to loss. Real estate is
interest-sensitive. With real estate 85% of collateral, KHCB is particularly
vulnerable to increases in interest rates.

Compounding this problem, KHCB’s real estate collateral is primarily
located in a single, very small market—Bahrain—, magnifying the inherent risks
of taking illiquid assets as collateral.

I
have relied primarily on the Pillar III note as the IFRS note really
doesn’t provide the same level of detail.

However, both have an
apparently erroneous and misleading statement regarding collateral coverage of
the portfolio.This error appears only
as a number in the Pillar III Note 4.10.Note 34 spells out the error:“The average collateral coverage ratio on secured facilities is
107.80% at 31 December 2015 (31 December 2014: 109.49%).”

As Pillar III Note 4.10 shows this
ratio was determined by taking the value of all collateral and dividing it by
outstanding exposure.

Two
problems with that.

First and foremost, Pillar III Note 4.10 shows that BHD
106.5 million is unsecured.The key point here is that if a loan is
unsecured, then by definition it has no collateral.Consequently, unsecured loans should be
excluded from measures of collateral coverage.That of course would apparently make the ratio higher at 148%. Note that the data for “Other” and “Unsecured” is switched in both the Arabic and English versions of the 2015 AR as evidenced by data in prior years’ annual reports.

Second, unless this collateral is
pledged to all secured facilities the 148% coverage ratio is
meaningless.

As a concrete example, suppose you take a $1mm loan from
Bank Arqala (“BA”), assuming you can pass our stringent credit process, and pledge The
Trump Tower in NYC.Our fine bank has
collateral worth let’s say a $1 billion, if not multiples more.But TTTNYC only secures your loan.If BA makes loans totaling $999 million to
other borrowers, the average collateral on the portfolio is not 100%.One loan for $1 million is over collateralized.It’s also important to remember that BA like
any other bank can only collect what you owe on your loan when it
sells (realizes) the collateral you pledged.If you owe $1.1 million in P&I, BA can take and sell the Trump Tower
but only keep $1.1 million not the untold billions TTTNYC is really worth. The bank must return the rest of the proceeds from the collateral realization to you.

Collateralization Levels

2015

2014

2013

2012

2011

Unsecured

106.5

105.2

55.9

47.9

40.3

Total
Gross Exposure

408.7

361.8

306.0

286.3

217.3

%
TGE

26.1%

29.1%

18.3%

16.7%

18.5%

Partially
Secured

25.0

17.9

9.9

10.8

12.2

%
TGE

6.1%

4.9%

3.2%

3.8%

5.6%

%
TGE –All Unsecured

32.2%

34.0%

21.5%

20.5%

24.1%

Comments on
collateralization levels:

As is clear, KHCB has
been expanding its unsecured portfolio.It was at 18.5% in 2011 and 26.1% in 2015. However, percentages don't convey the full extent of the change. Unsecured loans have gone from BHD 40.3 million to BHD 106.5
million. Why is that important? Because over the period capital has not increased by 2.5x.

In general, but not
always, uncollateralized lending is riskier than collateralized.Tenor (maturity) of the loans would also
affect risk.That info is not available.

Note the partially secured amounts are
net after deducting the partial collateral shown in Pillar III Note 4.10 for “cash” and
“other” collateral at face value (no haircut by AA).

First, real estate is illiquid and may
be hard to sell, unless one is holding a security interest in a piece of land
in central Tokyo.There’s probably not comparable
land in Bahrain.Additionally, it’s well
known that with the rightnautical partners one can create
perfectly good land in Bahrain from the sea as GFH and Arcapita might testify.Cash or marketable securities would be much
more liquid and provide much more protection.That’s why KHCB advances on average only 60 fils against each dinar of
real estate collateral.

Second, real estate is interest sensitive.As market rates rise so do cap rates (the
interest rates used to determine the value of the property). As a consequence,
property values decline.That could be a
problem as the US raises interest rates and currency pegged-Bahrain follows
along.The main consequence is likely to
be eroding collateral values. Borrowers are shielded from rising rates by the fixed
rates on their existing loans--absent covenants in the loan agreements that
allow the bank to raise borrower’s interest rates.Thus, borrowers’ ability to repay should not
be affected directly, though general interest rate could indirectly
stress their ability to repay by reducing overall economic activity in the
Kingdom.Potential buyers of “seized”
collateral are likely to require financing.If rates on new loans are higher than currently, the sale of real estate
will be more difficult, perhaps requiring KHCB to make loan term concessions or
reduce the price of seized property being sold.That leads nicely into the next point.

Third, when looking at an institution’s exposure to real estate
risk, one needs to look at more than the purpose of the loan or the business of
the borrower. If a bank makes a loan for a new airline, but secures it with
real estate, it has an indirect exposure to real estate along with the direct
exposure to the airline.If the loan is
being made because the real estate collateral “compensates” for shortcomings in
the airline’s creditworthiness, then the exposure to real estate is more
“direct”.

Some 55% of KHCB’s exposure (based on outstanding exposure not
collateral values) is secured by real estate, which tempers KHCB’s
management’s statement at the bottom of the chart in Pillar III Note 4.3.6 page
88:“The Board
approved internal cap for real estate exposure at 40% of total assets. The Bank’s
real estate exposure as of 31 December 2015 and 2014 are within the policy
limit.”Not exactly. Assuming collateral is taken because it is
needed to support extension of credit, then KHCB’s real estate exposure is
larger than 40%.